THE BEAR'S
LAIR Draining national
prosperity By Martin Hutchinson
The 0.6% rise in first quarter US gross
domestic product was greeted with considerable
relief by most Wall Street commentators. They had
expected the chaos in the housing market and the
banking system to have pushed the US economy into
recession. This was unreasonable. The huge
monetary stimulus being hurled at the economy was
always likely to prevent immediate recession,
while the fiscal stimulus of the US$110 billion
rebate package is likely to prop it up through
July or so. Beyond that, the future becomes less
clear: at some stage the monetary and fiscal
stimulus must run out.
As I have
frequently written, monetary conditions have been pretty
lax since 1995. It had
been becoming difficult to determine how lax since
March 2006, when the Federal Reserve stopped
reporting M3 money supply, the measure used in by
the European Central Bank and other monetarist
organizations. However the St Louis Fed, which for
the decade until April was run by the monetarist
William Poole, has constructed its own measure of
broad money, Money of Zero Maturity, which is a
reasonable proxy for M3; it consists of M2 plus
institutional money market funds minus small time
deposits. Like M3, MZM began to expand excessively
in early 1995; in the 13 years to March 2008 it
grew at an average annual rate of 8.88%, compared
with growth in nominal GDP during that period of
5.25%.
Thus monetary policy, however
measured, has been excessively expansionary since
1995, in the sense of expanding the money supply
faster than output. As I have written previously,
the inflation-creating effect of this excessive
monetary expansion has been suppressed for a
decade by the Internet, which has had a similar
deflationary effect through enabling outsourcing
to cheap labor countries that the railroads and
refrigeration did in the 1880s through allowing
cheap agricultural produce from the Midwest,
Canada, Australia and Argentina to be shipped
worldwide.
From the beginning of 2008,
however, monetary expansion has sharply
accelerated. In the three months to April 21, the
latest data available, MZM expanded at an annual
rate of no less than 28.7%. This extra-rapid
expansion is not surprising; the Fed has been
terrified that the US financial system is about to
collapse and has been making funding available in
large quantities in a variety of ways. Indeed, on
May 2, the Fed, concerned about the credit-card
financing market, allowed banks to use
credit-card-backed AAA bonds as security for Fed
loans. Needless to say this involves yet more
monetary expansion and further risk to the
taxpayer. Monetary stimulus of this extraordinary
magnitude will have an effect. It has to.
Other countries have also been expanding
their money supply excessively. The European
Central bank has allowed euro M3 to expand by
11.1% in the three months to March 2008, following
an increase of 11.5% during 2007. As in the United
States, this increase is much faster than that of
nominal GDP and it had been continuing for several
years, with annual growth rates of 7.4% in 2005
and 10.0% in 2006. Of the major emerging markets,
China and India have both been operating
expansionary monetary policies and now have
considerable inflation problems. Vietnam too has
been surprised in spite of its rapid growth by
inflation surging towards 25%. Only in Japan,
where "broadly-defined liquidity" has been
increasing at rates in the 3-4% range in 2006-08,
has monetary policy been reasonably consistent
with low inflation.
Monetary stimulus
generally works with a lag of several months at a
minimum. Thus it is likely that the extremely lax
monetary conditions of the past few months have
not yet produced their full effect. Nevertheless
it is remarkable how rapid has been the advance of
energy and commodity prices, with the Reuters CRB
commodity price index up 24% since the Fed began
its misguided interest rate cutting campaign on
September 18 last year.
It is also
remarkable how feeble growth in the United States
has been. With the Fed essentially printing money
as fast as it could, the US economy grew only 0.6%
in each of the fourth and first quarters. Since
the US population increases by around 1% per
capita, the economy has thus been in a per capita
recession since September. In the first quarter
indeed, even ignoring population growth, the
economy was only pushed above the flatline by
increases in inventory and government spending,
both detrimental to economic output in the long
term.
Over the next several months, it is
likely that current trends of feebly advancing GDP
and soaring commodity prices will continue.
Certainly the stock market seems to think so; it
has recovered nicely from its mid-March low and is
now above the levels when the crisis hit last
August, even though earnings in the financial
sector, representing more than 40% of total US
earnings before crisis hit, have essentially
disappeared in the last two quarters. The Fed may
not at present intend to push interest rates down
further, but it has already forced them more than
2% below even the thoroughly fudged statistics of
inflation produced by the Bureau of Labor
Statistics.
It is perhaps disappointing
for bears that a crisis may not occur immediately,
but there can be no question that the vigorous
monetary and fiscal medicine administered by the
Ben Bernanke Federal Reserve and the George W Bush
administration will have its effect. Indeed, far
from declining in the second quarter, as has been
confidently predicted, gross domestic product may
even tick up a bit, boosted by monetary and fiscal
stimulus, perhaps to around 2% or 1% after
population increase has been taken into account.
At some point, a crisis will arrive.
Inflation in the eurozone, China and India is
already at levels deemed unacceptable, while even
Japan has positive inflation for the first time in
many years. In the United States, the producer
price index increased 6.9% in the year to March,
while that for crude goods increased more than
30%. Like a bowling ball swallowed by a python,
that inflation will move through the economic
system and eventually be reflected in consumer
prices.
Indeed, it may already be showing
up there; the seasonally unadjusted consumer price
index for March was up 0.9% (an annual rate of
around 11%) and only a heroic seasonal adjustment
of 0.6%, double the next-largest seasonal
adjustment for any month in the last 10 years,
brought the figure down to an acceptable 0.3%.
The Bureau of Labor Statistics explains on
its website that its seasonal adjustment
methodology changed in January; should it be the
case that this is being used to suppress consumer
price inflation, even the dozier members of the
media will come to notice after another couple of
months have passed. In any case, it is likely that
by the latter part of 2008, consumer price
inflation in the US will be running at more than
10% and that even the heroic mavens at the BLS
will be unable to suppress that information
completely (though on past form they will
undoubtedly try.)
There will come a point
at which the irresistible force of gradually
increasing GDP and continually optimistic stock
market will meet the immovable object of consumer
price figures that can no longer be ignored. At
that point, the US will suffer not merely a
monetary crisis but a political crisis. President
Bush, with his refusal to see recession, Treasury
Secretary Hank Paulson, with his background in an
institution (Goldman Sachs) and a market (the Wall
Street of 1995-2007) that together bear a very
substantial responsibility for the problem, and
Bush’s Fed appointee (chairman Bernanke), with his
continual insistence that inflation is imminently
about to disappear, will be discredited by reality
and unable to provide leadership. Awkwardly, it is
more likely than not that the crisis point will
occur before November, so there will be no
fresh-faced president-elect to take control of the
situation.
Almost certainly, it will prove
impossible to put the entire US economy on ice
until January 20, 2009, so the financial markets
themselves, probably the Treasury bond market,
will take control. With the US Treasury’s funding
need in the fiscal years 2008 and 2009 already
around $500 billion in each year, hiccups in the
bond market have an almost immediate way of making
themselves felt. To avoid a collapse in the bond
market and a catastrophic decline in the dollar as
foreign central banks withdraw their money,
short-term interest rates will have to be raised
very quickly to at least 3% above the then
prevailing level of inflation. That would imply a
level of 7-8% today, but probably considerably
more by the time the crisis hits.
Once
interest rates have been raised, inflation will
not decline immediately, but nor will the US
descend into a re-run of the Great Depression.
There will be a lengthy and grinding recession,
probably persisting throughout 2009 and into 2010,
with GDP declining maybe 4-5% from top to bottom
and inflation coming definitively under control
only towards the end of the period.
On the
other hand, the dollar will stop being weak, since
US interest rates will be internationally
attractive, and the US balance of payments
position will swing back sharply towards balance
as US consumption and therefore imports decline
sharply. The US savings rate will also increase,
allowing the country to finance new capital
investment from domestic resources, and giving it
once more a substantial capital cost advantage
over the emerging markets with lower labor costs.
The wild card will be politics. It is not
yet clear who will be the next president, and it
is abundantly clear that this pretty unpleasant
economic environment will dominate that
president’s first two years in office. As happened
to Herbert Hoover, it will be possible for the new
president and/or Congress, through misguided
protectionist or anti-capitalist policies, to make
things sufficiently worse that a Great Depression
Mark II ensues.
Since none of the three
remaining leading presidential candidates has a
firm, well thought-out commitment to economic
policies that would alleviate or solve the
problem, and all have tendencies that might
exacerbate it, the safest choice is probably to go
for raw intelligence, and hope that the new
president can learn on the job.
Which is
as close as this column is going to get to an
endorsement!
Martin Hutchinson
is the author of Great Conservatives
(Academica Press, 2005) - details can be found
at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice &
Associates.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
